WIKIFX REPORT: EFTs - What are they and how can you trade them?

Exchange-traded funds (ETFs) combine aspects of mutual funds and conventional stocks. Like a mutual fund, an ETF is a pooled investment fund that offers an investor an interest in a professionally managed, diversified portfolio of investments. But unlike mutual funds, ETF shares trade like stocks on stock exchanges and can be bought or sold throughout the trading day at fluctuating prices. It can contain, for example, stocks of companies that operate in a particular sector, such as oil producers. It can be even more specific and may only contain companies that are connected to US shale oil, for instance.

By grouping together different companies in a related field, an ETF can give you exposure to a specific sector while simultaneously providing diversification. You can easily get exposure to all the companies within the ETF, which would be time-consuming and expensive if you bought all the individual stocks yourself. So, bundling these companies together in an ETF makes it much cheaper to trade than a basket of individual stocks, and more convenient.

You can trade in and out of an ETF with the single click of a mouse. You can also go short, trade on margin, and purchase small amounts if you wish. In addition, there are ETFs which have been structured to track a specific investment strategy, such as taking a leveraged short position on US stock market volatility.

ETFs versus Mutual Funds

When you purchase or sell ETF shares, you receive the market price on the exchange at the time the order is placed. This price may fluctuate throughout the trading day. A mutual fund, on the other hand, determines its net asset value at the close of each trading day. When you purchase or redeem mutual fund shares, you receive the price based on the net asset value next computed after you submitted your order.

ETFs are often compared to mutual funds, but there are a few fundamental differences. For a start ETFs are exchange-traded, just like a companys stock. This means they can be bought and sold throughout the trading day, quite unlike a mutual fund.

Additionally, the holdings in an ETF are disclosed each day to the public, whereas that happens monthly or quarterly with mutual funds. Most ETFs are passively managed investments in that they simply track an index, such as the S&P 500, or NASDAQ 100. Some investors prefer the more active and hands-on approach of mutual funds which are run by a professional manager who tries to outperform the market. Although there are actively managed ETFs that mimic mutual funds, these come with higher fees.

Index ETFs

There are hundreds of ETFs in existence, with new ones created all the time. An ETF creator, or sponsor, is typically an institution which groups together baskets of assets under one banner with its own stock market identifier, or ticker. The ETF provider then sells shares in that fund to investors. These investors then own a portion of an ETF, but not the underlying assets in the fund.

But investors in an ETF that tracks a stock index may receive dividend payments, or reinvestments, for the stocks that make up the index. While many ETFs are designed to track the value of an underlying asset or index, typically they trade at market-determined prices that usually differ from that asset. In addition, there are usually costs involved which the sponsor will cover through adjustments to the price of the ETF which means that longer-term returns for an ETF will vary from those of its underlying asset.

Inverse and leveraged ETFs

When you buy an inverse ETF on an index such as the S&P 500, youre hoping to make a profit if the underlying index falls in price. This can be an effective way to hedge a portfolio of stocks, rather than going to the expense and bother, not to mention dealing with the possible tax implications, of borrowing and then shorting, or even closing out multiple positions on individual stocks.

However, many traders warn that because of the way an inverse ETF is structured, it should only be used as a short-term hedging method. In essence, due to their structure which can involve forwards, swaps and futures, inverse ETFs are designed for traders looking for short-term tactical trades. This may not be the right vehicle for you, so make sure you carry out thorough due diligence.

There are also many popular leveraged ETFs. These are designed to multiply your profits by a factor of two or even three, assuming you correctly identify which way the market moves. These can enhance your returns on sharp moves in the right direction. But you will also accumulate losses at a similarly high-leveraged level if you are wrong. Like inverse ETFs they are only suitable for short-term holdings, and even if you get the overall direction of travel correct, they can still result in losses if held for more than a day or two.

ETF Expenses

In addition to any brokerage commission you may pay, ETFs have expense ratios, like mutual funds, calculated as a percentage of the assets you have invested. ETFs do not have loads or 12b-1 fees (fees that are taken out of a mutual fund's assets annually to cover the costs of marketing and distributing the fund to investors).

In general, actively managed ETFs cost more than passively managed index ETFs. Before purchasing ETF shares, carefully read all of an ETFs available information, including its prospectus. All ETFs will deliver a prospectus upon request.

ETFs and Taxes

You can own ETFs in taxable, tax-deferred or tax-free accounts. In taxable accounts, any capital gains you realize from selling fund shares are taxed in the year you realize them, though the rate that applies may be your long-term capital gains rate.

Note: you can never ask too many about the contents of an ETF. There may be stocks in there that you‘d rather not own, or which may not align with the type of exposure you’d like to take. For instance, it is often the case that an ETF has a heavy weighting towards just one or two stocks. Similarly, it could exclude smaller, and potentially more interesting stocks, possibly because their market capitalisation may be below a certain threshold and deemed unsuitable to hold in the ETF by the sponsor.

You may be perfectly happy with that, or you may feel that the ETF isn‘t giving you the kind of exposure that you’re after. Another issue is that ETFs have become victims of their own success. They have proved very popular with both investors and traders, and this has encouraged sponsors to create new funds. Unfortunately, this means that trading volumes can be extremely light in some ETFs, which makes them illiquid and difficult to trade. So, the bottom line: make sure you know what youre buying, and that it fits in with your investing style.